Stablecoins are on the rise, and they are filling a void for the burgeoning tokenized economy. A void created by unintended consequences of the cryptocurrency success story; they incentivize trading and investing at the expense of use as a medium of exchange. A common conundrum faced by crypto owners who believe that a price surge is around the corner is – do I hold, or do I spend? The crypto movement has created an active community of holders. As the community feverishly works to resolve the scaling problem and bring transaction volume closer to par with Visa, we are still left with tokens that some are reluctant to use as a medium of exchange. While this may be temporary – as decentralized cryptocurrencies evolve, it certainly poses a challenge for projects that rely upon a stable value token to facilitate transactions today. Stablecoins offer a solution that promises to enable some projects in the tokenized economy to gain traction. These centralized solutions, however, are not without quirks that may render them undesirable under certain circumstances.
A stablecoin is essentially a token, such as bitcoin, on a blockchain – but one that is pegged to a state-issued currency such as the U.S. Dollar, where one token equals one dollar. This stable value token can be purchased with fiat currency or cryptocurrency. It can be redeemed at any time for the underlying currency on which it is based. You can think of stablecoin as the tokenization of fiat currency, a digital proxy for cash, or a cash-collateralized token. Tokens offer several benefits over the underlying currency. To name a few: as a proxy for fiat currency – they can be as reliable as the dollar, they are not vulnerable to counterfeit like paper money, they can be used in smart contracts to transfer value without an intermediary, they are accessible for global transactions 24 hours every day, their native environment is the blockchain where transactions are fast and inexpensive, and they enable commerce with state-backed currency in the token economy. But all stablecoins are not created equal, and therefore should be evaluated individually to determine suitability for specific applications.
Characteristics of a stablecoin
Filling a void
In the token economy fiat currency plays a crucial role; most users will not likely mine cryptocurrency, but rather acquire it with fiat. This necessary interaction with fiat currency introduces friction in an ecosystem striving to eliminate drag. Fiat creates friction in part because it cannot be exchanged directly on a blockchain. As an example, consider the time, cost, and risk involved in transferring value from one cryptocurrency exchange to another to access a smart contract or token that is not available on the user’s current blockchain network. The simplest means of transfer would be to send bitcoin from one exchange wallet to the other, but that involves risk that the user may not be prepared to take at the time. The user may be holding cash in their exchange account and prefer to avoid the volatility risk. This cash would need to be withdrawn to a bank account, and then transferred to the next exchange account where the user can access the smart contract or token. Not only can these interactions with banks introduce several days in delay, they typically include transaction costs charged by the bank and the exchange. In contrast, with access to a stable coin at both exchanges, the user can convert their fiat in their exchange account to a stablecoin, and transfer the stablecoin to the next exchange without delay – while eliminating the costs of intermediaries. The added bonus is an ability to take advantage of time sensitive opportunities that otherwise would elude the user.
Powering smart contracts
Smart contracts enable value to be transferred without intermediaries based upon predefined criteria. Value can take the form of a token such as ether on the Ethereum network. However, the volatility of ether may render it undesirable for a contract. Using a stablecoin handsomely resolves the problem by embedding a proxy for fiat into the token economy; in so doing it also improves the utility of money.
How stablecoins are created
I will highlight two approaches to bringing a stablecoin into existence. Stablecoins may be pre-mined, or created at the time of issue. Pre-mining generates a pool of stablecoins for the issuer to offer for trade on a blockchain exchange. An issuer who pre-mines 1 million stablecoins pegged to the U.S. dollar, for example, would deposit an equal amount of USD into a trust, and increase or decrease the USD holdings to reflect the value of outstanding stablecoins. Alternately, an issuer may generate stablecoins as they are issued. In this case when a user offers $1,000 for an equal amount in stablecoins, $1,000 worth of stablecoins would be generated and issued to the user, and $1,000 in USD would be placed in trust to fully back the issued tokens. The user of a stable coin may trade the token on a secondary market to other users. If the stablecoin is redeemed directly with the issuer for USD, and the issuer withdraws the funds from the trust – then an equivalent value of tokens should be destroyed, again insuring that funds in trust cover all outstanding tokens.
Trust and reliability
Stablecoins enable the use of fiat currency equivalent tokens on a blockchain. Users need to be assured that the token is truly backed by a state issued currency. This assurance is realized through a few leading practices which include:
- Maintaining an equal value of fiat currency (such as USD) in a trust to back all outstanding tokens
- Deposit all collateral fiat currency into an insured and regulated bank
- If necessary deposit collateral fiat currency into multiple banks to ensure that all funds are insured
- Conduct regular (monthly/quarterly) independent audits to demonstrate that the issuer has enough fiat currency on deposit to back all outstanding tokens
- Make audits publicly available
- Implement independent audit of smart contracts
- Transparency
Compliance
Unlike the typical cryptocurrency that we have become accustomed to, stablecoins are incorporating features that limit their unrestrained predecessors. These features may also render the new class of crypto more suitable for applications where compliance requirements exist. Features include the ability to interrupt a transaction offline with a smart contract that relies upon input from an external off-chain oracle in order to execute under certain conditions. Additionally, stablecoin smart contracts can enable pausing, blocking, or reversing token transfers to comply with regulatory requirements and thwart fraud or other illegal transactions. Moreover, stablecoins can be encoded with parameters governing their use.
Centralized
Stablecoins have an inherent reliance on a central authority to actively administer the token and ensure that each outstanding token is backed by fiat currency. The issuer of a stablecoin may also own the trust company that acts as custodian of the collateral fiat currency. This centralized nature of stablecoins relies upon trust, which requires an issuer to demonstrate transparency to build confidence in the user community. Tether, the best-known stablecoin, parted ways with their external auditor, as reported by CoinDesk, leaving the community uncertain about the state of their U.S. dollar holdings to back up their outstanding stablecoins – which is approaching $3 billion at the time of this writing according to CoinMarketCap.com. Tether chose to engage a law firm to validate its reserve holdings according to Reuters. However, this has not quelled concerns that Tether’s unencumbered cash reserves have not been adequately verified – hence the need for greater transparency.
Engineered for use, not holding or investment
Because stablecoins are pegged to a state backed fiat currency, they are not subject to the wild price volatility that we observe in decentralized crypto. Mirroring the price fluctuations of an underlying fiat such as USD means that the stablecoin will not be an attractive vehicle for speculators, holders, or traders – anymore than the underlying currency. Accordingly, the incentive of a stablecoin lends itself to use cases that align with the traditional definition of currency: a medium of exchange, a store of value, and a unit of account.
Not all stablecoins share all of the characteristics set out here, and this is by no means a comprehensive list of all characteristics of stablecoins, however we have touched on some key elements. If you are interested in exploring more information about stablecoins, here is a sample of some projects: TrueUSD, Terra, Tether (USDT), Paxos (PAX), and the recent Gemini dollar (GUSD) which was built to the ERC-20 standard to operate over the Ethereum network. Some projects claim to be FinCEN compliant, regulated by the U.S. Securities and Exchange Commission, or approved by the New York Department of Financial Services (NYDFS). As always, I recommend conducting your own due diligence to verify claims of issuers.